This MFA Perspective is designed to guide companies in the proper accounting for complex financial instruments. It provides a comprehensive summary of the GAAP that applies to issuers of convertible securities, freestanding warrants, and puts and calls, as well as highlights common issues that should be considered in debt and equity financings.
This webpage contains the first two sections described in the Table of Contents. Click here to download the printer-friendly PDF version and continue reading the full MFA Perspective.
Table of Contents
- Background and Purpose
- Redeemable Preferred Stock, Warrants for Redeemable Preferred Stock, and Puttable Warrants
- Embedded Conversion Options
- Puts and Calls Embedded In Debt
- Electing The Fair Value Option
- Balance Sheet Classification of Shares
- Allocation of Proceeds and Journal Entries
- Earnings Per Share
- Deferred Income Taxes
- Debt Issue Costs, Debt Discount or Premium, and Preferred Stock Discounts
- Conversion Accounting and Changes in Conversion Option Accounting After Issuance
- Troubled Debt Restructuring, Debt Modification and Extinguishment
As the design of financial instruments continues to evolve, public and private companies have increasingly entered into creative financing transactions. These transactions often involve the issuance of conversion options embedded in debt or preferred shares (such as convertible debt or convertible preferred shares) and freestanding warrants to purchase the issuer’s shares. We have received many questions about accounting for these types of transactions. The SEC staff frequently questions whether the appropriate accounting analysis has been performed, and as a result of these questions a number of companies have restated prior financial statements. The purpose of this document is to summarize the GAAP that applies to issuers of convertible securities, freestanding warrants, and puts and calls, and to discuss other common issues that should be considered in debt and equity financings.
Companies should begin the analysis by identifying the financial instruments issued. For example, a company may have issued one instrument with embedded conversion options or two freestanding instruments (e.g., nonconvertible debt with detachable warrants). It is important that companies read the contracts thoroughly to identify all of the terms that may require recognition in the financial statements. Companies are faced with additional challenges if the terms of a financing are scattered in several different agreements. For example, a capital raising transaction frequently includes a securities purchase agreement, a warrant agreement, and a registration rights agreement.
Initially, companies should determine whether the instruments they issued are considered freestanding or embedded, i.e., combined with another contract. This determination is a matter of judgment. Accordingly, the following questions should be considered:
- Was one contract issued in contemplation of and simultaneously with another contract? For example, were nondetachable warrants issued in conjunction with debt?
- Can the holder of the contracts sell, transfer and/or exercise each contract separately? For example, must the debt be tendered in order to exercise the warrants?
- Were the contracts executed with the same counterparty either directly or through an intermediary?
- Do the contracts or transactions relate to the same risk?
- Is there an apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction?
Different accounting conclusions may be reached based on whether contracts are evaluated separately or as a single combined unit. As such, this decision must be made prior to identifying the appropriate literature to apply. In particular, ASC 480-10 (Statement 150) applies only to freestanding instruments, whereas ASC 815 (Statement 133) provides guidance for hybrid instruments, i.e., contracts comprised of a host such as a debt instrument and an embedded feature such as a conversion option.
After reading the contracts and identifying the financial instruments, companies should answer the following questions that are discussed in detail in this Perspective for each instrument:
- Is the freestanding financial instrument redeemable preferred stock, a warrant for redeemable stock, or a puttable warrant, i.e., is it within the scope of ASC 480-10 (Statement 150)?
- Does the financial instrument include embedded conversion options?
Is the issuer required to bifurcate the conversion option from the host contract under ASC 815 (Statement 133)? That is:
Does the embedded conversion option meet the ASC 815-10-15-74 (Statement 133, paragraph 11(a)) scope exception? If the answer to each of the following questions is yes, derivative accounting is not required. That is:
- Are the economic risks and characteristics of the embedded conversion options clearly and closely related to the economic risks and characteristics of the host contract? If yes, bifurcation is not required.
- Is the hybrid instrument (i.e., the contract comprising the host and the embedded conversion options) remeasured to fair value at each balance sheet date with changes reported in earnings? If yes, bifurcation is not required.
- Would the embedded conversion option, if freestanding, qualify as a derivative under ASC 815-40 (Statement 133, paragraphs 6 – 9)? If no, bifurcation is not required.
- Is the embedded conversion option indexed to the company’s own stock under ASC 815-40-15 (EITF Issue 07-5);
- Can the embedded conversion option be classified in shareholders’ equity under ASC 815-40 (EITF Issue 00-19, paragraphs 1-11); and
- If the hybrid instrument is convertible, is it conventional convertible; or, if it is not conventional convertible, can the embedded conversion option be classified in stockholders’ equity under ASC 815-40 (Issue 00-19, paragraphs 12-32)?
- Is the freestanding warrant indexed to the company’s own stock under ASC 815-40-15 (EITF Issue 07-5);
- Can the freestanding warrant be classified in shareholders’ equity under ASC 815-40 (Issue 00-19, paragraphs 1-11); and
- Can the freestanding warrant be classified in stockholders’ equity under ASC 815-40 (Issue 00-19, paragraphs 12-32)?
These questions will be addressed in-depth and analyzed in the context of examples and case studies for R Company.
STEP A: Is the financial instrument within the scope of ASC 480-10 (Statement 150)?
Freestanding Financial Instruments
Step A in analyzing a complex financial instrument is to determine whether it falls within the scope of ASC 480-10 (FASB Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity). The following three categories of freestanding financial instruments are required to be accounted for as liabilities under ASC 480-10 (Statement 150):
- Mandatorily redeemable shares;
- Instruments (other than an outstanding share) that do or may obligate the issuer to buy back some of its shares (or are indexed to such an obligation) in exchange for cash or other assets — e.g., written puts (puts written by the issuer on its own shares and held by others); and
- Obligations that must or may be settled with a variable number of shares the monetary value of which is based solely or predominantly on — 1) A fixed monetary amount known at inception; 2) A variable other than the fair value of the issuer’s shares such as a market index; or 3) A variable inversely related to the fair value of the issuer’s shares.
The second category of instruments falls under ASC 480-10 (Statement 150), but is not germane to the analysis of shares. If the shares do fall into categories one or three, they are measured initially at fair value. If the shares do not fall into categories one or three, the instruments must be analyzed under ASC 815 (FASB Statement 133, Accounting for Derivative Instruments and Hedging Activities).
Category One – Mandatorily Redeemable Shares
Mandatorily redeemable shares are shares that an entity is required to redeem for cash or other assets at a fixed or determinable date or upon an event that is certain to occur. Mandatorily redeemable shares should be measured subsequently in one of two ways:
- If both the amount to be paid and the settlement date are fixed, those instruments shall be measured subsequently at the present value of the amount to be paid at settlement, accruing interest cost using the rate implicit at inception; or
- If either the amount to be paid or the settlement date varies based on specified conditions, those instruments should be measured subsequently at the amount of cash that would be paid under the conditions specified in the contract if settlement occurred at the reporting date, recognizing the resulting change in that amount from the previous reporting date as interest cost.
Any amounts paid or to be paid to holders of such instruments in excess of the initial measurement amount should be reflected in interest cost.
Some preferred share instruments are required to be redeemed at a stated date and are within the scope of ASC 480-10 (Statement 150). However, a convertible preferred share that is redeemable at a stated date would not meet the definition of a mandatorily redeemable share, because it would not be redeemed if the holder chose to convert to common shares (assuming that the conversion right is substantive). (These shares should be reported as temporary equity. See the section on Balance Sheet Classification of Shares.)
Category Three – Obligations that Must or May Be Settled with a Variable Number of Shares
The concept of predominantly in this third category of obligations that must or may be settled with a variable number of shares is not defined in ASC 480-10 (Statement 150) and is not straightforward. ASC 480-10-55 provides guidance and states that the issuer must analyze the instrument at inception and consider all of the possible outcomes to reach a conclusion as to which obligation is predominant. The issuer should consider all information that is on point including current stock price, stock volatility, strike price, and any other relevant factors.
Some companies may interpret predominance as anything in excess of 50%, similar to the more-likely-than-not threshold in ASC 740 (FASB Statement 109, Accounting for Income Taxes) while others may attach a higher probability of 70%, 80% or 90%, etc. We believe either approach is acceptable and must be documented and consistently applied as an accounting policy election.
Obligations to issue a variable number of shares should be measured subsequently at fair value with changes in fair value recognized in earnings, unless other GAAP specifies another measurement attribute. In practice, it may be acceptable for companies to consider certain obligations to settle in a variable number of shares with a value based solely or predominantly on a fixed monetary amount known at inception as, in substance, stock-settled debt. Further, the interest method (as defined in the ASC’s Master Glossary) is typically used for the periodic amortization of discount or premium on debt instruments.
A common example of instruments in the third category is a $100 borrowing that requires the issuance, at the end of one year, of a variable number of shares with a then current value of $125. The instrument is accounted for as a liability at fair value as it is not equity to the issuer because the holder is indifferent to changes in the value of the shares.
Certain convertible preferred shares are liabilities under the third category of ASC 480-10 (Statement 150). These instruments are issued in the form of preferred shares that are convertible into a variable number of common shares (i.e., the “conversion price” continuously resets), the monetary value of which is fixed, tied to a variable such as market index, or varies inversely with the value of the issuer’s common shares.
ASC 480-10-55 (FSP FAS 150-1, Issuer’s Accounting for Freestanding Financial Instruments Composed of More Than One Option or Forward Contract Embodying Obligations under FASB Statement 150) and ASC 480-10-25 (FSP FAS 150-5, Issuer’s Accounting under FASB Statement 150 for Freestanding Warrants and Other Similar Instruments on Shares That Are Redeemable) explain that freestanding warrants are obligations for the company to repurchase its shares (or instrument indexed to its shares) and represent liabilities if:
- The warrants (or instruments indexed to the company’s shares) are puttable, OR
- The warrants (or instruments indexed to the company’s shares) are exercisable for shares that are puttable or mandatorily redeemable.
This guidance applies regardless of the timing of the put or the redemption price because the underlying instruments represent obligations to transfer assets.
Examples of warrants that would be classified as liabilities under ASC 480-10 (FSPs FAS 150-1 and 150-5) include the following......click here to download the full White Paper in a printer-friendly PDF format.
 For instruments issued by nonpublic companies that were mandatorily redeemable on fixed dates for fixed amounts or by reference to an interest rate index, currency index, or another external index, ASC 480-10 (Statement 150) became effective for fiscal years beginning after December 15, 2004. For all of the other financial instruments of nonpublic companies that are mandatorily redeemable, the provisions of ASC 480 (Statement 150) were deferred indefinitely.